Are alternatives a good substitute to bonds for pension schemes?

However, we are now in a world where the global economy is transitioning from a ‘restoration phase’ of strong growth, rising equity markets and higher corporate bond yields, to the ‘expansion phase’ of the business cycle. 

This means that while there will be continuing economic progress, the return outlook for investment markets becomes tougher for most liquid asset classes.

Adding to this, a higher inflation regime may undermine the diversification properties of government bonds, especially considering the already low yield on offer in many developed market countries in the wake of quantitative easing. 

In an environment where most asset classes are either neutrally valued or looking expensive, and where bonds may not act as a reliable equity hedge, we have seen an increasing interest by pension funds in adding some alternatives into their asset allocation mix

Growing interest in alternative assets

In an environment where most asset classes are either neutrally valued or looking expensive, and where bonds may not act as a reliable equity hedge, we have seen an increasing interest by pension funds in adding some – or more – alternatives into their asset allocation mix.

In fact, most of our client conversations now include an exchange of ideas and views around private assets, direct lending, infrastructure debt, and natural capital. 

We are also seeing more interest from smaller schemes to explore allocations to alternatives. 

Until recently, allocations to alternatives have principally been made by larger institutional investors, since they usually have more resources to assess the risk and opportunities associated with the inclusion of new asset classes in their allocations – and have the necessary scale to access more opportunities. 

But, innovation in this area and consolidation in the market are helping smaller schemes to increasingly engage in the conversation.

The ‘diversifiers’ and ‘return enhancers’

Alternatives can play many different roles in a portfolio, but we broadly see them as falling into two groups: First, there are the ‘diversifiers’. Most liquid alternatives such as commodities, trend following and some hedge fund strategies tend to fall into this group. Typically, these assets have different factor exposures to equities (ie, low market beta and correlation).

And while it is true that there is a trade-off between long-term performance and the reliability of the hedge for many liquid alternatives, their diversifying attributes remain attractive options in a world where government bonds may be losing their diversification properties.

The second group of alternatives are ‘return enhancers’. This group typically includes less-liquid asset classes such as private equity, private debt and infrastructure.

While there is evidence that illiquid alternatives may also contribute to portfolio diversification, their main role in portfolios tends to be return enhancement, as their main economic source of returns is similar to that of liquid asset classes.

In my conversations with pension schemes over the past few years, the main reason they give for buying private assets has not been for reducing correlations or downside protection, but to achieve higher returns over liquid assets.

The constraint of lower liquidity

However, there is a balancing act needed here as investments in these strategies often come with lower liquidity, the so-called ‘lock-up’, which may last over the course of years.

In contrast, many defined benefit schemes, especially in the UK, have increasing liquidity needs as they turn cash flow negative or explore derisking strategies like buy-ins or buyouts.

Trustees are therefore often faced with the dilemma of reconciling the schemes’ evolving liquidity requirements with the differing profiles offered by alternative assets.  

This delicate balancing act requires trustees to think about the size of the allocation to illiquid assets and how this can be aligned with the cash flow profile of the scheme’s liability.

There is no one-size-fits-all answer. However, as there is an expanding range of alternative assets available with a wider range of return, risk and cash flow profiles, UK DB schemes are increasingly able to allocate to these assets to help achieve their mission and maintain portfolio diversification.

Moreover, these alternative assets may also support schemes as they seek to achieve their own climate and environmental, social and governance objectives.

Many alternative investment strategies are increasingly influenced by the growing relevance of these factors, the changing regulatory landscape, and the growing demands of asset owners to invest in a manner that recognises both traditional financial factors and the financial materiality of ESG and climate issues.

Maria Ryan is head of institutional sales for the UK, Mena and Nordics at HSBC Asset Management